Catalysts for a USD reversal

Posted on 19 October 2010

Currency markets are prone to over-enthusiam. The fast paced, high volume trade offers an accelerated incubator for credible ideas. A catchy concept can quickly gather a life of its own - escaping the bounds of the inter-bank market and taking sentiment to extremes.

The US$ has been the focal point of the latest fad to sweep the financial landscape – the QE2 ignited self immolation of the US economy. Signs are that this idea is approaching its use-by date. Given that the ‘risk trade’ has been feeding off weakness in the US$, think we can expect any retracement to work its way through commodities, emerging markets, credit spreads and, ultimately, equities.

What signs?

1) The Commitments of Traders reports for last week had the futures markets back to square which historically has been a pre-condition to a trend reversal. This is a little counter-intuitive in the context that we are looking for extreme positions but the futures markets are a mere drop in the ocean against the over-the-counter FX market. We will be looking for whether large traders continue to sell the US$ or commence building long positions. Recent history would suggest that they have form in calling the turn. (Chart from Finviz)

2) Sentiment measures - As Traders Narrative noted last week (you’ll find the chart here) – the Daily Sentiment Index put together by trade-futures.com is plumbing new depths that indicate the market is extreme in its views, if not positions.

3) November FOMC meeting – the over-anticipated trigger event is creeping closer. Bernanke and his chums are in a corner over QE with reasonable odds that just about anything they mutter will fail to satisfy the hype. In this context, it’s interesting to consider that the recent collapse in equity volatility looks to be the result of punters selling the upside – rather than buying it. Call option volume spiked even as the VIX dropped back through 20.

4) The political imperative – enter stage left Timothy Geithner (here) which suggests that the administration will be playing up the value of the dollar over the near term. No politician worth his salt is going to openly support the ‘currency wars’ – especially when he is sharing the same plate of pickled ginger (G-20 website here).